Key employees are “key” because they have a significant impact on the current and long-term success of the business. Hence, the business owner(s) will want to be intentional and strategic in aligning compensation and incentive plans for those key employees with the owner’s goals for business growth and exit. Owners should also protect against the potential loss of these valued employees due to death or disability, as their loss can be quite damaging and even destructive to business value and future growth. Following are suggested steps to take in assigning value to your key employees.
First, it’s important to identify the key employees of your business. An employee should be considered “key” to the success of a business if they:
make a substantial business contribution (i.e., marketing, sales, administrative) and/or…
possess critical knowledge or information (i.e, products, service, customers, operations) and/or…
maintain and develop key contacts and relationships (i.e., customers, suppliers, vendors, etc.)
Once key employees are determined, an insurable value must be assigned to each, which is generally more difficult than assigning value to physical, financial, or real assets. A value must be estimated for the amount of insurance to be purchased by the business on the employee’s life. The value of the key employee to the employer combined with the employee’s anticipated replacement costs equals the amount of insurance that should be purchased.
There are a number of methods that can be utilized in determining the value of a key employee or manager. Following are methods most often used:
Multiples of Income Method: The easiest and probably the most common method used. Insurance companies often estimate the amount of key insurance needed on a multiple of 5-7 times an employee’s total compensation.
Replacement Cost Method: The cost to locate, recruit, and train a suitable replacement.
Employee’s Contribution to Earnings Method: The earnings of a business, for purposes of estimating the insurable value of a key employee, come from its return on invested assets and the skill of the management team (plus expenses for recruiting and training replacement).
Present Value of Lost Earnings Method: Estimate the business’ lost earnings resulting from the loss of a key employee. The present value of the lost earnings plus the expense of recruiting and training a replacement becomes the insurable value of the key employee.
One Year’s Business Earnings Method: This method is generally considered to have the least credibility as it is not based on the actual or perceived value to the employer. But instead, it simply determines insurable value by assigning an amount equal to the total of the prior year’s before-tax earnings (plus expenses for recruiting and training replacement).
Protecting the value of your key employees is a critical step in protecting the value of your business. Oftentimes, until a sellable business value is built and realized, the most key employee is the owner(s).
For assistance, contact your insurance professional or contact us at email@ennislp.com or 301-859-0860.
